Medicare is America’s largest public health program and one of the largest programs overall in the federal budget. For over 40 years Medicare has played an important role in improving the economic security and well-being of our country’s seniors. In 2011 Medicare provided benefits to over 40 million seniors and more than 8 million others with disabilities. Currently there seems to be widespread misunderstanding of how this important program is paid for and fear on the part of those still working that Medicare will not be there for them. In our previous article we discussed the various components of Medicare. Now, let’s talk about how the program is financed and what it pays for.

In 2011 Medicare benefit payments totaled $550 billion, funded mostly from three sources; general tax revenues (43%), payroll tax contributions (37%), and Medicare beneficiary premiums (13%). In broad terms, Medicare is financed by two “trust funds”, the Hospital Insurance (HI) Trust Fund and Supplementary Medical Insurance (SMI) Trust Fund, both of which are overseen by a board of trustees that makes an annual report to Congress concerning the financial status of the funds. These two funds pay for the services of its four programs, also known as Medicare Parts A (Hospital Insurance), B (Supplementary Medical insurance), C (Medicare Advantage), and D (Prescription Drug). Of the $550 billion, 35% is allocated to Part A, 30% to Part B, 23% is to Part C, and 12% to Part D.

The Hospital Insurance (HI) Trust Fund pays for Medicare Part A services including inpatient hospital services, nursing facilities, and some home health care. This fund is financed primarily (84%) by the 2.9 percent payroll tax, shared equally by employees and employers, and to a lesser extent from income taxes paid on Social Security benefits, interest earned on the trust fund investments, and beginning in 2013, the new Medicare payroll and investment income surtaxes on higher income earners.

The Supplementary Medical Insurance (SMI) Trust Fund consists of two separate accounts, one which pays for Medicare Part B (physician, outpatient, and other medical services), and the other which pays for Medicare Part D (prescription drugs). The SMI Trust Fund is financed primarily (approximately 75%) from the federal government’s tax revenues collected from individuals and corporations. The balance of 25% is paid from beneficiary premiums, deductibles and coinsurance.

Medicare Part C, also known as Medicare Advantage, is a private plan alternative for beneficiaries that covers all Part A and B services. There is no separate trust fund to pay for Part C services. It is funded proportionately from the HI and SMI trust funds.

It is important to point out that the Medicare trust funds we have discussed are accounting mechanisms. In other words, there are no actual cash transfers into and out of specifically designated Medicare accounts. Instead, income to the trust funds is credited to the fund in the form of interest-bearing government securities, and expenditures for services that are paid by the U.S. Treasury are debited to the fund. In many respects, this structure is similar to the way individuals save and invest in financial institutions. Our savings accounts don’t hold actual cash but rather represent accounting entries that are backed by the promise of the bank (an IOU) to pay us cash when we demand it.

Now that we understand how Medicare is funded, in our next article we will discuss the financial challenges facing this program and the reason it has become one of the hottest issues in the policy debates over reducing federal budget deficits and debt.